Playing the Fed’s Next Rate Move

Jerome Powell has a reputation for being a consensus builder. In a town like Washington that lives on conflict, the Federal Reserve chairman reportedly managed to offend no one before rising to his present position in February 2018. Yet he has offended and annoyed the man who made him the most powerful person in global financial markets—President Donald Trump.

Powell’s recent congressional testimony could be construed as hinting that the central bank may lower rates, as Trump wants. The market expects a rate cut of 25 to 50 basis points. (A basis point is 1/100th of a percentage point.)

Of course, if the Fed fails to lower rates, Powell will almost certainly become the target of Trump’s wrath, and speculation will surge that he may even lose his job. The president recently tweeted that the Fed is America’s most pressing problem, something meaty for investors to chew on before the bank’s rate-setting committee prepares to meet on July 30-31.

This historically unusual relationship between two of the world’s most powerful people now permeates every conversation about markets. Investors mostly seem to be half-mad in anticipation that stocks will rally higher should interest rates ultimately be lowered. If nothing happens to change rates, or if the rate cut is lower than expected, stocks could plummet.

“The question is if the Fed put is worth more to the market than earnings. We will find that out in two weeks,” said Steve Sosnick, Interactive Brokers’ chief market strategist. “Right now, the market is telling you that it loves the Fed put and that there’s no inflation except in financial assets, which benefits those who hold financial assets.”

The Fed put, of course, refers to the central bank’s willingness, since the financial crisis, to lower rates to support the economy and the market. Low rates favor risk assets, including stocks, and investors have become addicted to the idea that the Fed will always seek to accommodate the market.

Hence, many investors are updating valuation models ahead of the Fed meeting. If capital is cheap, and they can borrow money at lower rates, they can make more money on stocks. Of course, corporate earnings remain a wild card. Bad earnings reports will create incredible tension, as now-bullish models will likely have to be lowered despite low rates.

In recent weeks, we’ve detailed an all-weather playbook for the current market. If you think stocks will rally after the Fed meeting, buy call options on the SPDR S&P 500 exchange-traded fund (ticker: SPY). If you think stocks will go lower, buy SPY puts. (Calls increase in value when the underlying security price increases; puts increase in value when security prices fall.)

If you have little idea what may happen—or want to make money regardless of how the stock and options markets respond to the Fed news—the exchange-stock play, which we recently recommended, remains intriguing. Trading volumes, which are the lifeblood of exchanges, should surge on the Fed news. A rate cut would likely cause investors to buy loads of stocks. The absence of a rate cut would likely cause them to sell.

Shares of
Intercontinental Exchange
(ICE) and
Nasdaq
(NDAQ) have sharply outperformed the S&P 500 index since our May 30 recommendation. Intercontinental has since gained about 11%, and Nasdaq is up about 12%, compared with a 7% gain for the market.
Cboe Global Markets
(CBOE) and
CME Group
(CME) have slightly lagged the benchmark index’s gains.

Still, it is likely that the exchange thesis is not yet fully ripe. The sector does not get that much attention from analysts and investors as, say, the always popular technology arena, which is dominated by the likes of
Apple
(AAPL),
Alphabet
(GOOGL), and
Amazon.com
(AMZN).

If you like the exchange thesis, you can buy stocks, buy calls, or sell puts to gain or increase exposure. Focus on contracts that expire in three months or less, as a lot can happen. Any resolution to the U.S. and China trade war would also send stocks higher.

This copy is for your personal, non-commercial use only. Distribution and use of this material are governed by our Subscriber Agreement and by copyright law. For non-personal use or to order multiple copies, please contact Dow Jones Reprints at 1-800-843-0008 or visit www.djreprints.com.